On 4 June 2020, the European Banking Authority (EBA) published a consultation paper (PDF) setting out draft regulatory technical standard (RTS) for implementing the new prudential regime for investment firms. 

Among other topics, the draft RTS specify methods for the calculation of the own-funds requirements of investment firms on a solo basis, the most important one of which is the K-factor requirement.

This blog post is one of a series and summaries:

  • EBA’s draft RTS on methods for measuring the K-factors (‘draft RTS 7’); and
  • EBA’s draft RTS on the calculation of the amount of the total margin for the calculation of the K-factor K-CMG (‘draft RTS 10’).

The final RTS shall apply from June 2021. EBA has requested comments on its consultation paper by 4 September 2020.  

The K-factor requirement

Under art.11(1) of the 2019 investment firms regulation (IFR), investment firms shall at all times have own funds that amount to at least the highest of:

  • the fixed-overheads requirement calculated in accordance with art.13 of the IFR - for more details see our blog post here;
  • the permanent minimum capital requirement in accordance with art.14 of the IFR; or
  • the K‐factor requirement calculated in accordance with art.15 of the IFR.

The K-factor requirement is only a component of the capital requirement for those investment firms that are not considered small and non‐interconnected investment firms (art.12(1) of the IFR).

The K-factor methodology aims to be a tailor-made approach to determining the level of own funds that is sufficient in relation to the different types of risks investment firms pose to clients, the market and themselves.

Accordingly, K-factors are divided into the following sub-categories:

  • Risk‐to‐Client (RtC);
  • Risk‐to‐Market (RtM); and
  • Risk‐to‐Firm (RtF).

Under art.15(1), (2) of the IFR, the overall K-factor requirement is the sum of the K‐factor requirements under RtC, RtM and RtF multiplied by certain risk-weighted coefficients. The following chart provides an overview:

Art.15(5)(a) of the IFR mandates EBA to specify the methods for measuring the K‐factors by submitting draft RTS to the Commission by 26 December 2020.

However, EBA chose not to further specify some K-factor requirements as IFR sufficiently details the methods for measuring them.

In EBA’s view, K-NPR, K-TCD and K-CON would not benefit from further clarifications. For K-NPR, IFR refers to the market risk requirements of the capital requirements regulation (CRR) while, for K-CON and K-TCD, IFR itself sets out detailed and comprehensive technical provisions which correspond to a simplified application of the relevant requirements under the CRR.

Draft RTS 7 details how to calculate K-AUM, K-ASA, K-CMH, K-COH and K-DTF, and introduces a general principle regarding the use of tied agents, whereas draft RTS 10 comprises further specifications on determining K-CMG.

Draft RTS 7

Tied agents

Since investment firms take on full and unconditional responsibility for investment business undertaken by their tied agents, EBA proposes to apportion the investment business of a tied agent to the responsible investment firm for calculating the investment firm’s K-factor requirement.

However, as the use of tied agents is only relevant for certain business activities, this rule shall solely apply to the RtC K-factors K-AUM, K-CMH, K-ASA and K-COH.

Accordingly, art.1 of draft RTS provides that investment firms shall include within each of AUM, CMH, ASA and COH any amounts that relate to the investment services and activities of the investment firm carried out by their tied agents.

Therefore, investments firms cannot decrease the aforementioned RtC K-factors and eventually their own funds requirement by using tied agents. 

K-AUM in the context of certain advisory arrangements

‘AUM’ is defined as the value of assets that an investment firm manages for its clients under both discretionary portfolio management and non-discretionary arrangements constituting investment advice of an ongoing nature (art.4(1)(27) of the IFR).

The draft RTS 7 details how to calculate K-AUM in relation to such non-discretionary advisory arrangements of an on-going nature.

Under art.2(1) of draft RTS 7, EBA proposes to exclude from being calculated within K-AUM the provision of advice to undertakings on capital structure, industrial strategy and related matters, and advice and services relating to mergers and the purchase of undertakings. This is because these services are considered corporate finance advice rather than investment advice.

Further, draft RTS 7 details how to calculate K-AUM where an investment firm provides investment advice to another financial entity.

By way of background, art.17(2) of the IFR provides that, when calculating K-AUM, assets whose management has been formally delegated by an investment firm to another financial entity will be attributed to the delegating investment firm – and not to the delegate.

The intention was to avoid ‘double counting’ where two authorised firms (namely an investment firm and an AIFMD/UCITS management company) are involved and would otherwise both include the same portfolio assets within their respective K-AUM calculation (see para.50 of the consultation document (PDF).

The legislator decided that it should be the entity that maintains the direct client relationship that should take into account the corresponding assets for calculating its K-AUM requirement.

Art.2(2) of draft RTS 7 specifies the allocation of assets of investment firms providing discretionary portfolio management services that use the investment advice from another investment firm (or an AIFM/UCITS-company) under non-discretionary advisory arrangements of an on-going nature.

In this context, the principle to avoid double counting does not apply. Rather, both the investment firm providing investment advice and the firm providing portfolio management services must include the relevant assets in their calculation of K-AUM. This applies regardless of whether the investment firm providing investment advice maintains a direct relationship with the client.

The difference to the aforementioned delegation provision under art.17(2) of the IFR is that the business relationship of the two financial entities does not qualify as the delegation of one service (and the two entities engaging in different parts of that one service) but as a provision of two different services (see para.50 of the consultation document (PDF).   

Differentiation between K-AUM, K-CMH and K-ASA

The draft RTS also considers the differentiation between various K-factors, including between K-AUM, K-CMH and K-ASA. In general, EBA intends to avoid double counting as it would increase capital requirements for the same level of risk.

Since client money held is already included in the calculation of K-CMH, art.3(3) of draft RTS 7 specifies that only such cash shall be included in the calculation of K-AUM that is not yet covered by art.4 of draft RTS 7 as CMH (see para.45 of the consultation document (PDF)). Similarly, the calculation of the amount of ASA shall exclude CMH (see art.5(b) of draft RTS 7).

Accounting standards for K-AUM and K-ASA

Draft RTS 7 also details the applicable accounting standards for calculating the amount of AUM and ASA. ASA means the value of assets that an investment firm safeguards and administers for clients, irrespective of whether assets appear on the investment firm’s own balance sheet or are in third‐party accounts (art.4(1)(29) of the IFR).

To calculate the level of AUM and ASA, arts. 3(a) and 5(a) of draft RTS 7 set out that financial instruments should be valued at their fair value in accordance with applicable accounting standards.

EBA clarifies that fair-value accounting applies in principle to all positions (including derivatives and cash). It shall encompass the market value or estimated values in accordance with the hierarchy of IFRS 13 or other applicable accounting standards.

If there is no valuation immediately available in the market, the hierarchy for the fair valuation should be used, depending on the market information available.

With regard to AUM, EBA says that, in order to properly capture the value of all AUM, no offset should be taken into consideration, including for the instruments that might have a negative value. Therefore, art.3(2) of draft RTS 7 requires investment firms to take the absolute value for calculating the amount of AUM where the fair value of a financial instrument is negative (see art.3(b) of draft RTS 7).

K-CMH

Draft RTS 7 details how to calculate K‐CMH. CMH means the amount of client money that an investment firm holds, taking into account the legal arrangements in relation to asset segregation and irrespective of the national accounting regime applicable to client money held by the investment firm.

K-CMH captures the risk of potential harm of an investment firm holding the money of its clients, taking into account whether:

  • they are on its own balance sheet or in third‐party accounts; and
  • arrangements under applicable national law provide that the client money is safeguarded in the event of bankruptcy, insolvency, or entry into resolution or administration of the investment firm.

K‐CMH excludes client money that is deposited in a (custodian) bank account in the name of the client itself, where the investment firm has access to the client money via a third‐party mandate.

Further, the risk-weighted coefficient differs depending on whether the client money is held on segregated or non-segregated accounts (see art.15(2), Table 1 of the IFR).

You can find further details on these requirements and the related draft RTS in in our blog post.

Art.4 of draft RTS 7 sets out that K-CMH shall be measured:

  • based on balances that the investment firm would use for its internal reconciliations; and
  • by using values contained in the investment firm’s accounting records.

Therefore, investment firms can use the values contained in their internal records, eg their cash books, rather than values contained in statements received from their banks and other third parties.

K-COH and K-DTF

Draft RTS 7 clarifies K-COH and K-DTF, which may be regarded as complementary K-factors:

  • ‘COH’ is defined as the value of orders that an investment firm handles for clients via the receipt and transmission of client orders, and through the execution of orders on behalf of clients (art.4(1)(30) of the IFR);
  • ‘DTF’ means the daily value of transactions that an investment firm enters through dealing on its own account or the execution of orders on behalf of clients in its own name.

Under art.2(2), subpara.6 and art.4(1)(33) of the IFR, attribution of an asset to COH and DTF is mutually exclusive. Draft RTS 7 clarifies and avoids arbitrage between these two K-factors that are, in fact, not single K-factors but the sum of two K-factors based on the kind of trade, ie cash trades or derivatives, to which different coefficients apply (0.1 per cent for cash trades and 0.01 per cent for derivatives – art.15(2) of the IFR).

Arts 8 and 10 of draft RTS 7 have identical provisions regarding methods for measuring cash trades for COH (art.8 of draft RTS 7) and DTF (art.10 of draft RTS 7) while art.9 (COH) and art.11 (DTF) of draft RTS 7 set out identical rules for determining the notional amount of derivative contracts. The only difference between these pairs of rules is presumably a typo in art.10(2) of draft RTS 7.

Under arts 8 and 10 of draft RTS 7, cash trades are any transactions where a counterparty undertakes to receive or deliver transferable securities, money-market instruments, units in collective investment undertakings, and exchange traded options. Articles 9 and 11 of draft RTS 7 specify that the notional amount of a derivative contract shall be determined according to art.29(3) of the IFR, which takes a more sophisticated approach to determining the ‘notional amount’ with regard to the calculation of K-TCD as it sets out different calculation measures depending on the type of derivative.

Due to the distinction between cash trades and derivatives, there are actually four separate components in practice when it comes to K-COH – one for execution in the name of the client and one for the receipt and transmission of orders, both of which may have cash trades and derivative trades or orders. Accordingly, art.6 of draft RTS 7 specifies the measurement of COH for executions of client orders in their name, while art.7 of draft RTS 7 concerns the receipt and transmission thereof.

In order to establish a level playing field in different jurisdictions for the calculation of COH in relation to the execution of client orders, art.6(1) of draft RTS 7 sets out that the investment firm shall include a transaction when it receives confirmation that the order is executed and the price is known. Art.6(2) of draft RTS 7 provides that, in order to avoid double counting, client orders received from another firm shall only be included in the measurement of execution of client orders, not in the calculation of the receipt and transmission of client orders.

Draft RTS 7 further clarifies when an order shall be included in an investment firm’s K-COH in the context of the receipt and transmission of an order. For example, bringing together two or more investors as corporate finance or private equity transactions is excluded from being calculated as the receipt and transmission of an order (art.7(2) of draft RTS 7), as is matching third-party buying and selling interests arising from the operation of a ‘multilateral trading facility’ or an ‘organised trading facility’ (art.7(4) of draft RTS 7).

Draft RTS 10

The RtM K‐factor requirements K-NPR and K-CMG apply to all trading book positions. Irrespective of whether an investment firm is dealing on own-account deals for itself or on behalf of a client, the applicable RtM K-factor requirement is either K-NPR or K-CMG.

As stated above, EBA believes the methods for calculating K-NPR are sufficiently detailed in the IFR, which simply references the market-risk requirements set out in the CRR, ie using the standardised approach, alternative standardised approach or alternative internal model approach (cf. art.22 (a)-(c) of the IFR). For these market-risk requirements, there are detailed provisions in the CRR.

K-CMG provides an alternative to K-NPR for calculating the RtM requirement for the trading book positions for an investment firm dealing on its own account. According to art.23 of the IFR, the competent authority may permit an investment firm dealing on its own account to use the K-CMG for positions that are subject to clearing or margining under the responsibility of a clearing member, provided that a number of conditions are satisfied, including that the competent authority is convinced that the portfolios subject to K-CMG were chosen not with the aim of engaging in regulatory arbitrage of its own funds in a disproportionate or prudentially unsound manner (art.23(1)(e) of the IFR).

Art.2 of draft RTS 10 details how to calculate the amount of CMG in general and art.3 of draft RTS 10 contains certain rules for calculating K-CMG in case of multiple clearing members. Further, art.4 of draft RTS 10 sets out the conditions under which the competent authority might assess whether a change of the utilised RtM K-factor is due to regulatory arbitrage.

EBA proposes that the investment firm must continuously compare its capital requirement under the K-NPR and K-CMG calculation and be able to justify significant deviations.

A couple of other provisions target the potential loophole that arises from the possibility of using a different RtM factor approach for different trading desks. For example, art.1 of draft RTS 10 defines ‘trading desk’ and, under art.4(1)(b) of draft RTS 10, the investment firm must deploy either the K-NPR or the K-CMG approach consistently across all trading desks so defined that are similar in terms of business strategy and trading book positions. Further, investment firms must wait at least two years before switching from one approach to the other (art.4(2(a) of draft RTS 10).

Conclusion

EBA’s draft RTS 7 and 10 provide certain clarifications that aim to avoid double counting and regulatory arbitrage at the same time.

Nevertheless, it appears that the most significant requirements on how to measure the K-factors are already set out in the primary legislation.